Cries of Abuse Grow with Use of Complex Hidden Stock Orders

Allegations of abuse over how a stock trade is executed may soon bring a new black eye to Wall Street or amount to little more than another warning about high-frequency trading.

NEW YORK -- Allegations of abuse over how a
stock trade is executed may soon bring a new black eye to Wall
Street or amount to little more than another warning about
high-frequency trading.

The numerous order types - the instructions that govern
price and other variables in a trade - and their use by
high-frequency traders have sparked a growing debate over the
structure of the U.S. marketplace.

Order types can reach an estimated 2,000 variations as a
fully electronic market and more than 50 trading venues have
multiplied the possibilities of how, when and with whom to
trade. And they have changed how buying or selling interest in
the market is detected.

Using order types to outsmart other traders has become the
latest skirmish in a battle over the merits of high-frequency
trading. While the proliferation of new order types baffles many
market participants and has sparked talk of abuse, little proof
of manipulation has shown up so far.

The largest and most powerful traders in the market use
order types to gain a more favorable position in the order book
and the exchanges have helped their best clients achieve that
edge, said Sal Arnuk, a co-founder of brokerage Themis Trading
LLC in Chatham, New Jersey.

"My point is the exchanges are providing their largest
customers by revenue and volume, guaranteed economics. If that's
not a red flag, I don't know what is," he said.

For their part, officials at U.S. exchanges are adamant that
new order types are transparent and fully disclosed.

Gary Katz, president of the International Securities
Exchange, a leading U.S. options exchange, said complaints about
poor disclosure are unwarranted as exchanges are required to
make documentation on new order types available to everyone.

"This is a fully transparent mechanism," Katz said at a
convention of the Security Traders Association in Washington
last month.

Exchange officials deny they serve special interests, noting
the Securities and Exchange Commission approves all new order
types. The exchanges answer critics by saying some traders have
figured out how order types can work to their advantage while
other traders have failed to do their homework.

A source at the SEC said the most sophisticated exchange
users go to great pains to figure order types out. Even if some
may benefit certain participants more than others, "I don't know
that there's necessarily fire there," the source said.

But critics say the confusion from order types allows only a
few investors to profit from the changes.

"The pace at which order types are changing and morphing is
faster than ever," said Chris Nagy, president of KOR Trading
LLC, a consultant to exchanges and brokerages, pointing to a
steady stream of regulatory filings for new order types whose
complexity, he said, confounds even professional traders.

Themis Trading's Arnuk finds especially troubling so-called
"hidden" order types that are non-routable, which means orders
can be kept from going to another exchange to be executed at
less favorable terms. Arnuk said such orders are abusive as the
user can wait for a trading opportunity that better suits their
needs.

Both Nagy and Arnuk called for a moratorium on order types,
and Themis has urged the SEC to annul most order types and set
up a panel to scrutinize any new proposals.

Exchange operator BATS Global Markets said in February that
the SEC had sought information about the development,
modification and use of order types, and its communications with
certain market participants, including members that are
affiliated with its stockholders and directors.

A moratorium would limit competition and would not be in the
best interest of the U.S. market, said Chris Isaacson, chief
operating officer at BATS, speaking at the securities traders
convention.

New order types help create a more efficient market by
allowing trading to occur in "different ways, in different time
frames with different objectives," he said.

Traders can stipulate the time an order is in force, how
much of an order will be held back in reserve, whether the price
will be displayed or not and how it will be routed, in various
combinations. BATS lists nine main order types on its website.

But, "if you count all those unique permutations you get to
2,000 and you create what can count as one, which is a limit
order," he said.

Limit orders are among the most common order types. But one
limit order, where the price is "hidden" or not always
displayed, has been flagged by critics as suspect because its
price can slide up or down as the market moves. While that move
raises hackles, it can also improve an incoming order's price.

The SEC allowed hidden orders to prevent the bid, or what a
buyer is willing to pay, and the asked, or the offer price, from
locking, the market's term for when both quotes are the same.

In March 2004, when trading was slower and there was less
volume, Nasdaq found that quotes locked or crossed - when the
offer price is lower than the bid and vice versa - more than
500,000 times on average every day.

Few people outside of high-frequency traders understand
hidden orders, said Lionel Mellul, a co-founder of Momentum
Trading Partners LLC, a brokerage that closed in July.

"From my experience that type of order is acting like a
ghost and that's the beauty of it, clients just can't detect
them," Mellul said.

Haim Bodek, a former trader at UBS who founded a
high-frequency options trading firm that was shut in 2011,
believes traders have gained an unfair advantage through hidden
orders. He outlined his concerns this week in an extensive
critique on the Tabb Forum, a website dedicated to market
issues.

Exchanges have not mandated the use of hidden orders, Bodek
acknowledged, and he wrote: "Yes, speed matters -- but only if
you know what order type to send and when to send it."

Bodek declined to comment when contacted by Reuters. Bodek's
lawyer, Shayne Stevenson, a partner at Hagens Berman in Seattle,
said Bodek has brought his complaints to the SEC.

"The only public comment we have is that we believe the
evidence will show that the abusive properties of these order
types were not disclosed by the exchanges and that financial
institutions should be aware of these abuses," Stevenson said.

It's unclear how regulators will react to the allegations,
which are directed at institutional investors. Most agree that
for the retail investor, trading is cheap and efficient.

The SEC does not require a limit order to be displayed if a
customer, because of a trading strategy, so wishes. But how an
exchange discloses its order types is paramount to regulators,
who insist the rules be coherent and adhered to.

"The statute doesn't say, 'We can't have complexity in the
marketplace,'" said Gregg Berman, a senior adviser at the SEC.
"It doesn't demand simplicity; it demands fairness, equitable
treatment," Berman told a conference of the Securities Industry
and Financial Markets Association in New York two weeks ago.

(Reporting by Herbert Lash; Additional reporting by John
McCrank; Editing by Kenneth Barry)